Case Study: Evaluating a SPY LEAPS Option – Is It Overpriced? ??

Let’s revisit a real-world example of evaluating a SPY LEAPS (Long-term Equity AnticiPation Security) call option to determine whether it’s overpriced. For this updated case, we’ll consider a 2-year expiration and implied volatility (IV) of 14%, which are critical factors for pricing.

Scenario Overview

A trader is considering buying a SPY LEAPS call option with:

• Current SPY Price: $589.49
• Strike Price: $480 (~80 delta, deep ITM)
• Option Price: $155 to $160 (per share), or $15,500 to $16,000 per contract (100 shares per contract).
• Expiration Date: January 15, 2027 (2 years, ~730 days)
• Implied Volatility (IV): 14%

The key question: Is this option overpriced based on the given parameters?

Step-by-Step Analysis

1. Intrinsic Value

The intrinsic value represents the "real value" of the option if exercised immediately.

Intrinsic Value = Current Price - Strike Price = $589.49 - $480 = $109.49 per share, or $10,949 per contract.

This is the baseline cost, excluding any time or volatility premium.

2. Extrinsic Value

Extrinsic value accounts for time value and implied volatility. It’s the difference between the option’s price and its intrinsic value:

Extrinsic Value = Option Price - Intrinsic Value Using the midpoint price of $157.50: Extrinsic Value = $157.50 - $109.49 = $48.01 per share, or $4,801 per contract.

3. Analyze the Extrinsic Premium

To assess if the extrinsic value is reasonable, compare it to the intrinsic value:

Extrinsic Premium % = Extrinsic Value ÷ Intrinsic Value = $48.01 ÷ $109.49 ≈ 44%.

For deep ITM LEAPS, a reasonable extrinsic premium is typically 10%-15% of intrinsic value. At 44%, this is well above the expected range and indicates the option is overpriced.

4. Impact of Implied Volatility (IV)

With a 14% IV, the time value should be modest. Based on pricing models like Black-Scholes:

• The extrinsic value for similar LEAPS would typically fall in the range of $25-$35 per share, or $2,500-$3,500 per contract.
• The current extrinsic value of $48.01 per share is inflated, likely due to temporary market conditions or mispricing.

Fair Value Estimate

Based on the intrinsic value and 14% IV:

• Fair Extrinsic Value: ~$25-$35 per share.
• Fair Option Price: $135-$145 per share, or $13,500-$14,500 per contract.

At the current price of $155-$160, the option is overpriced by 10%-15% above fair value.

Why Is It Overpriced?

1. Time Decay Mispricing: Even with 2 years to expiration, paying a 44% extrinsic premium on a deep ITM option is excessive.
2. Implied Volatility (IV): A 14% IV suggests the extrinsic value should be lower, yet the current price suggests inflated premiums.
3. Liquidity or Demand: Wider bid-ask spreads or high demand for this strike may have pushed up the price.

What do you think you should do?

1. Reassess the Trade: Overpaying for extrinsic value reduces your margin of safety.
2. Check Alternative Strikes or Dates: Slightly OTM options or shorter-dated LEAPS may offer better value.
3. Use Limit Orders: Place a limit order closer to $135-$145 to avoid overpaying.
4. Monitor Implied Volatility: If IV decreases, the extrinsic premium will likely shrink.

Key Takeaways for New Traders

• Good Price Rule: For deep ITM LEAPS (like 80 delta), the extrinsic value should be around 10%-15% of the intrinsic value.
• Be Patient: Option prices fluctuate based on market conditions. Waiting for better pricing or exploring alternatives can save you thousands.
• Avoid Overpaying for Extrinsic Value: High premiums make it harder to profit unless the underlying stock rallies significantly.

Tags

#OptionsTrading #LEAPS #SPY #InvestingForBeginners #TradingTips #StockMarket101 #CaseStudy #FinancialEducation #RiskManagement

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